Dividend tax is changing but will the new £5,000 allowance save or cost you money from April 2016?

Dividend rules are changing on 6 April 2016 - saving one million people money on their tax bills, according to the Government.

The move, confirmed in the 2016 Budget, aims to encourage people to invest by introducing a new dividend allowance, whereby the first £5,000 of dividend income earned by shareholders each tax year will be tax-free.

Until then, while basic-rate taxpayers effectively pay no tax on dividend income, higher-rate taxpayers incur a 25 per cent charge and additional-rate payers have to fork even more on dividend income they receive.

Read our handy Q&A to find out what's changing and how you'll be affected.

Dividend allowance: You'll be able to receive £5,000 in dividend income from shares without paying tax

Tax on dividends

Due to a needlessly over-complicated system involving a notional 10 per cent tax credit, the current dividend tax confuses many people.

In theory, tax on dividends is paid at 10 per cent for basic-rate taxpayers and 35 per cent for higher rate taxpayers.

However, the tax credit cuts means that the effective rate of tax for basic-rate taxpayers is 0 per cent and for 25 per cent for higher-rate taxpayers.

From April 2016, the tax credit is being removed but a new £5,000 dividend allowance will be introduced - making this first amount of dividend income free of tax for all.

They must then pay tax on dividend income exceeding that amount.

The government says 95 per cent of all taxpayers, and more than three-quarters of all those who receive dividend income 'will either gain or be unaffected by these changes'. However, the change will be unwelcome to the people who have avoided the tax charge up until now - such as basic-rate taxpayers.

But the government insists 'only those with significant dividend income, or those who are able to pay themselves dividends in place of wages, will pay more tax'.

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HOW THIS IS MONEY CAN HELP

While many people will equate dividends with payments from shares that they hold, one of the key drivers of the new system is to crackdown on people using payouts to cut their work tax bills.

This is done by setting up a company, paying corporation tax on profits and then taking income as dividends.

The change will 'help address the incentive for some people to set up a company and make payments as dividends rather than as wages simply to reduce their tax bill, enabling the government’s plan to reduce the rate of corporation tax to 18 per cent by 2020,' according to the policy explanation at gov.uk.

What's changing?

Do your sums: While 1million people will be better off, some will have to pay more tax

The Government is ditching the dividend tax credit system that sees basic-rate taxpayers earn dividend income completely tax-free, while higher- and additional-rate taxpayers have to fork out 25 and 30.56 per cent on their dividend income respectively.

In its place will be an annual tax-free dividend allowance of £5,000 for all taxpayers.

How much will I pay on dividend income exceeding £5,000 a year?

This will depend on your tax band. Basic-rate taxpayers will be charged 7.5 per cent on dividend income over and above the allowance, while higher-rate taxpayers will incur a 32.5 per cent charge, and additional-rate payers 38.1 per cent.

How much would I need in my portfolio to generate £5,000 of dividend income?

Quite a lot. But it all depends on the yield.

For example, a share portfolio of £125,000 with a yield of 4 per cent will generate £5,000 income a year - using up the entire annual dividend allowance.

A portfolio of £500,000 yielding one per cent generates the same £5,000 a year.

I earn my dividend income from investments in my Isas. Do I have to pay tax?

No, as under the dividend tax credit scheme, dividends from shares held in Isas will continue to be tax-free under the new system.

What you'll pay: Under the new scheme basis-rate taxpayers will have to pay tax on dividend income for the first time, while the amount high-rate and additional-rate payers will be charged on income exceeding £5,000 will also rise

Do I get the dividend allowance on top of my personal allowance?

Yes. The dividend allowance is in addition to both your tax-free personal allowance for income tax (£11,000 from 6 April 2016) and your annual Isa allowance (£15,240).

For example, gov.uk explains that an individual with a salary of £20,000 who receives dividends of £6,000 outside of an Isa won’t pay tax on the first £5,000 of dividends due to the dividend allowance, but will pay tax on £1,000 of dividends at 7.5 per cent.

So what about someone on a salary of £40,000 who receive dividends of £9,000 outside of an Isa?

'Of the £40,000 non-dividend income, £11,000 is covered by the personal allowance, leaving £29,000 to be taxed at basic rate,' says the government.

'This leaves £3,000 of income that can be earned within the basic rate limit before the higher-rate threshold is crossed [£43,000]. The dividend allowance covers this £3,000 first, leaving £2,000 of allowance to use in the higher-rate band. All of this £5,000 dividend income is therefore covered by the allowance and is not subject to tax.

'The remaining £4,000 of dividends are all taxed at higher rate (32.5 per cent).'

I've never had to pay tax on dividends before, how do I pay it?

You will have to disclose the dividend income you receive during each tax year by completing a self-assessment tax return.

If you choose to complete a paper form, the deadline for submission is 31 October each year. If you choose to complete the online form, you will first have to register and you must submit it by 31 January each this year - this is also the deadline for paying what you owe whether you complete a paper or online form.

For more information on the dividend allowance and examples of what you might have to pay, see the government factsheet here.

I earn money through a company and pay myself with dividends, what should I do?

Those who earn money through a company and pay themselves with dividends should speak to their accountant for advice on how they will be affected by the changes, or seek out a good accountant.

They will need to take into account their business costs and other potential tax reliefs when making a decision on whether to change how they draw an income.